Q & A : How Rate Cut May Affect You

The Federal Reserve’s move Friday to slash interest rates could have a dramatic impact on both borrowers and investors. Whether the effect is good or bad will depend on the consumer’s situation.

Those who rely on monthly income from savings accounts are likely to be hurt by lower rates, while those who have borrowed heavily could end up with more spending money.

Here are answers to key questions facing consumers and investors:

Q: What is the discount rate?

A: It is the interest rate that the Federal Reserve charges member banks for loans. It is a barometer for all sorts of interest rates, since most banks price their loans several notches above the discount rate.

Q: Who is most affected by the rate cut?

A: The impact is immediately felt by savers and investors. For example, the moment the Federal Reserve slashed the discount rate, the yield on short-term Treasury bills plunged. Rates paid on certificates of deposit are loosely tied to how much the Treasury is paying on its bills, notes and bonds. So the bottom line is savers will be earning less on their money in the near future. Those who want to earn higher yields may have to put their money in riskier investments.

Q: What loan rates will be affected by the cut in the discount rate?

A: Typically when the discount rate falls, banks quickly cut their prime lending rates. On Friday, several slashed the prime a full percentage point to 6.5% from 7.5%. That affects how much businesses and consumers pay on all sorts of loans, including home equity lines of credit, consumer loans and some credit card rates.

Over time, mortgage rates will also probably drop, but not as steeply as the prime, said Paul Havemann, a spokesman for HSH Associates, a Butler, N.J., publisher of consumer lending information. Right now, a 30-year fixed-rate loan costs about 8.61% on average, while adjustable-rate mortgages go for roughly 6.19%. Havemann expects fixed-loan rates to fall about one-tenth of one percentage point the next few weeks, while the average rate on adjustables should drop by about one-quarter of a percentage point.

Q: What about credit card rates?

A: Most credit card rates are not affected by moves in the discount or prime rates. However, a handful of banks offer adjustable-rate credit cards that are usually tied to the prime. Banks have been under intense pressure to reduce credit card rates, and lower interest rates are likely to increase that pressure.

Q: Is it time to refinance your home mortgage?

A: It depends on how high your mortgage rate is, how much equity you’ve built up and how long you intend to stay in the home.

The rule of thumb is that market rates need to be at least two percentage points below your loan rate for refinancing to make sense. But those who intend to stay in the house longer may benefit from a refinance when there’s only a one percentage point drop.

Those who expect to move in the next five years should carefully consider the costs of refinancing before jumping at the lower rates.

Remember, there are significant up-front costs involved in a refinance. Typically, they can amount to between 2% and 3% of your loan amount. In other words, if you refinance a $100,000 loan, you’re likely to pay $2,000 to $3,000 in points, appraisal fees, loan origination costs and the like.

Q: What are the options for investors?

A: If you want to keep risks minimal, you might shift from Treasury bonds to high-grade municipal or corporate bonds. Those who have short-term certificates of deposit might move into longer-term CDs. Some may even consider putting money into stocks, although there are no guarantees in the stock market.

Q: How does this affect those already investing in stocks and bonds?

A: Generally speaking, it’s good news. The value of old, higher-rate bonds rises with every rate cut. Also, stocks usually do better in low-rate environments because lower-risk investment options are more limited and company profit often improves.

Q: Which makes more sense, a fixed- or adjustable-rate loan?

A: Those who expect to stay in the home for some time are probably better off with a fixed rate. Those who anticipate slow or no growth in their income also should stick with a fixed mortgage, so they are not harmed if interest rates pop back up.

But those who believe that they may move in the next several years and who have sufficient income to handle rate swings might consider adjustable loans.

Right now ARMs are significantly cheaper than fixed loans, and if the economy remains sour, these rates could stay reasonably low for some time. Up-front fees also can be cheaper with an ARM.

However, if you choose an adjustable loan, be sure you are familiar with the terms of the deal. Some loans adjust once a year; some adjust every month. Some will never go above certain rates, while others have no interest rate limitations at all.

Q: What about refinancing other types of debt, such as car and credit card loans?

A: There has been a big push in recent years to have people refinance their homes to pay off credit card bills and automobiles. Certainly this strategy can lower the interest rate you pay and provide tax savings as well. (Consumer interest expense is not tax-deductible, but home mortgage interest usually is.)

However, experts caution against risking your most valuable asset to pay for day-to-day living expenses. If you have sufficient equity in the home and the refinance is a one-shot deal that will forever clear you of revolving credit card debt, it might make sense. But if you refinance, then rebuild the credit card balance, you are slipping into a financial quagmire that could result in the loss of your home.

How Rates Will Be Affected The Fed announced Friday that it lowered two key rates: the discount rate--the interest it charges to make bank loans--to 3.5% from 4.5%, and the target for the federal funds rate--the interest that banks charge each other--to 4% from 4.5%.

As a result, many banks announced that they would cut their prime rates, the benchmark for many consumer and business loans, to 6.5% from 7.5%, the lowest level since 1977.

Economists said the cuts would have widely varying effects on interest rates most affecting consumers:

Adjustable-rate mortgages: Rates for some ARMs may be directly affected by Friday’s action, particularly those tied to money market rates that are in turn tied to the federal funds rate. Just how soon they will fall depends on the terms of the mortgage. On average, one-year ARM rates have already fallen to 6.33% in the fourth quarter from 7.63% in the first quarter.

Fixed-rate mortgages: These are tied more to long-bond yields and therefore are less affected by dramatic shifts in short-term rates. But they will undoubtedly feel a pull downward as well. Rates for a 30-year fixed-rate mortgage have fallen to 8.58% in the fourth quarter from 9.35% in the first. As a result, the rate of refinancing has skyrocketed. But a rule of thumb says to wait until rates drop at least two points below your current rate and to proceed only if you plan to remain in your home long enough to recoup the costs of refinancing.

Home equity loans: These rates tend to be tied to the prime rate and therefore will likely react swiftly and dramatically to Friday’s actions. Borrowers could expect to see drops of up to one percentage point by February.

CDs: Savers can expect rates to fall relatively quickly, perhaps in a matter of weeks. Because the rate is tied more closely to the federal funds rate, cuts would be on the order of half a percentage point, decreasing as the maturity of a CD account increases.

Credit cards: Don’t hold your breath for dramatic drops in rates. As the recession deepens, bad credit card debt goes up, and that cost must be covered by the remaining borrowers. Only increased competition, consumer pressure and introduction of variable-rate credit cards may push rates down. On average, in 1991 credit card rates have remained remarkably steady, at 18.83% in the fourth quarter compared to 18.87% in the first.

Source: Wells Fargo Bank, DRI/McGraw-Hill Inc., Bank Rate Monitor

Tumbling Interest Rates

The Federal Reserve lowered the discount rate--what the Fed charges member banks for loans--to 3.5% today, the lowest level in 27 years. The drop triggered cuts in both the prime rate and the federal funds rate.

Prime Rate: 6.5%

Fed Funds Rate: 4.0%

Discount Rate: 3.5%

THE IMPACT

Mortgage rates should head down quickly, benefiting both house hunters and borrowers who want to refinance. But qualifying for some ultra-low rate loans will become more difficult next year.

Rates on credit cards, unsecured personal loans and bank car loans are expected to remain at high, double-digit figures.

Business borrowers will continue to face difficulty getting credit, especially real estate developers. But those with access to credit will find the cost of money sharply lower.

WINNERS AND LOSERS The drop in interest rates is. . .

Good for businesses and consumers who are heavily in debt and who need to borrow. The drop will lower government borrowing costs thus easing the impact of the federal deficit.

The drop in rates was also good for the bond market, where prices rose sharply Friday.

Bad for savers and investors who have money in certificates of deposit or savings accounts that will pay lower rates of interest.

Also bad for the dollar and for such investments as gold, which usually perform better during periods of high inflation.

* MAIN STORY: A1